Masonite International Corporation
Q2 2018 Earnings Call Transcript

Published: 9 Aug 2018

[Operator:]

Welcome to Masonite Second Quarter Earnings Conference Call. During the presentation, all participants will be in a listen-only mode. After management's prepared remarks, investors are invited to participate in a question-and-answer session. Please note that this conference call is being recorded. I would now like to turn the call over to Joanne Freiberger, Vice President and Treasurer.

[Joanne M. Freiberger:]

Thank you, Dana, and good morning, everyone. We appreciate you joining us today. With me on the call today are Fred Lynch, Masonite's President and Chief Executive Officer; and Russ Tiejema, Masonite's Executive Vice President and Chief Financial Officer. We also have Tony Hair, President of Global Residential; and Graham Thayer, Senior Vice President and Business Leader of Architectural joining us for our Q&A session after the prepared remarks. We issued our second quarter earnings release yesterday. The release and information for the webcast presentation are available on our website at Masonite.com. Before we begin, I would like to remind you that this call will include forward-looking statements, including statements about our outlook in 2018 and our long-term growth framework. Each forward-looking statement contained in this call is subject to risks and uncertainties that could cause actual results to differ materially from those projected in such statements. Additional information regarding these factors appears in the section entitled Forward-Looking Statements in the press release we issued yesterday. More information about risks can be found under the heading Risk Factors in Masonite's most recently filed Annual Report on Form 10-K and on our Form 10-Q anticipated to be filed by Masonite with the SEC today. Our SEC filings are available at www.sec.gov and on our website at Masonite.com. The forward-looking statements in this call speak only as of today, and we undertake no obligation to update or revise any of these statements. Our earnings release in today's discussion includes certain non-GAAP financial measures. Please refer to the reconciliations, which appear on the tables of the press release and in the appendix of the WebEx presentation. The agenda for this call will include a business overview from Fred, followed by a review of our second quarter financial results from Russ, and a question-and-answer session. And then, we'll conclude with closing comments from Fred. And with that, let me turn the call over to Fred.

[Frederick J. Lynch:]

Thank you, Joanne. Good morning and welcome, everyone. We had another solid quarter with our consolidated net sales growing 9% year-on-year on strong performance from our acquisitions and higher average unit prices. The higher average unit pricing was demonstrated in all segments during the second quarter, combination of mix upgrades and like-for-like increases which helped mitigate the effects of a continued rising inflationary environment. Coupled with continued cost controls and operational improvements, these increases allowed us to grow adjusted EBITDA to $78 million in the second quarter, a 15% increase over the same period in the prior year. Adjusted EBITDA margin expanded 70 basis points from 13.1% in the second quarter of 2017 to 13.8% in the second quarter of 2018, again, with all segments contributing to this margin expansion. Despite the inflationary pressure on materials and labor being felt throughout the industry, Masonite effectively managed the price/cost relationship in Q2, aided by continued operational improvements throughout the second quarter. On last quarter's call, we mentioned the three key pillars of our strategy to achieve improved productivity

[Russell E. Tiejema:]

Thanks, Fred. Good morning, everyone. On slide 10, we summarize our consolidated financial results for the quarter. We had net sales of $566.7 million. As Fred mentioned, that's a 9% increase over the same period in 2017. Acquisitions and average unit price or AUP contributed approximately 5% and 3% respectively to this increase. Foreign currency also contributed 2% to the growth, and was partially offset by a 1% decline in base volume. Sales volume was up slightly in North America Residential, despite anticipated reductions in the retail business, but this was more than offset by sales volume reductions in the base business in Europe and Architectural. I'll talk about this in more detail when we cover the slide summarizing results in each segment. Gross profit increased 15.3% to $123.7 million, and gross margin increased 120 basis points to 21.8% of net sales, as we continued to achieve higher average unit price and make improvements in factory productivity. Adjusted EBITDA increased 14.6% to $78.3 million, and adjusted EBITDA margin expanded 70 basis points to 13.8%. Further to the key drivers of adjusted EBITDA, the bridge on the right side of the slide is an effective reminder of the significant inflationary environment we're navigating, and why price increases implemented since the fourth quarter of last year, along with our continued focus on manufacturing and distribution productivity, have been essential to us maintaining margins. Commodities inflation, most notably in wood, particularly in the UK, and resins and steel which most impact our North American Residential business, continues to be a significant headwind to our material cost. Recall that our expectation coming into 2018 was for full year commodity inflation of 3% to 3.5%. Following approximately 2.5% incurred in the first quarter, we saw commodity inflation further approach the 3% level in Q2. We foresee continued increases in the second half of the year, such that we're more likely to be near the upper end of our expected range for the full year, absent any further tariff-related increases. This highlights the need for us to not only improve average unit price, but continue to drive operational productivity. While costs shown on the EBITDA bridge indicate a slight increase in factory cost versus the same quarter of the prior year, this is net of wage inflation of approximately $4 million as well as a slightly higher cost mix of products in the quarter. These impacts were more than offset by improved factory productivity. SG&A increases were largely due to the impact of acquisitions and FX. After adjusting for these effects, the remaining SG&A increase shown on the bridge is largely explained by higher incentive compensation versus the prior year quarter, during which accruals were reduced to reflect lower performance versus planned. Absent higher incentive compensation accruals, SG&A as a percent of revenue would have been comparable to the prior year quarter. Net income for the second quarter was approximately $35 billion, and the diluted earnings per share was $1.24. Diluted EPS was up $0.35 per share from $0.89 per share in the second quarter of 2017, primarily due to higher pre-tax income, but also benefiting from lower tax expense and reduced share count. We continue to believe that our own company is a good investment. In the second quarter, we repurchased roughly 270,000 shares for $16 million at an average price of $61.09 per share. Now, turning to each of our reportable segments, beginning on slide 11 with North American Residential, where net sales increased 3% in the second quarter and adjusted EBITDA increased 8.1%. Sales volume was relatively flat with less than a 1% increase in the quarter. While we benefited from high-single digit growth in our wholesale business during the quarter, this was largely offset by declines in our retail business due to sales losses related to a customer line review launched in late 2017 as discussed on our Q4 2017 earnings call. Excluding the impact of this retail line review loss, we would have seen net sales growth solidly in the mid-single digits for the overall segment. Both average unit price and foreign exchange grew by 1% year-on-year in the quarter compared to the prior year. Like-for-like pricing was up across all channels of products, but product category mix and channel mix limited average unit price gains compared to the other segments. More specifically, we saw a lower mix of prehung doors as a result of higher wholesale versus retail growth. Despite continued material cost headwinds in the quarter, we were able to expand North American Residential adjusted EBITDA margins by 80 basis points to 15.6%, due to a combination of improved factory and distribution productivity, and higher average unit prices. Turning to slide 12 and our Europe segment. Net sales in the quarter increased by 36% compared to the same period last year, primarily driven by acquisition-related growth of 25%. As you might recall, we purchased DW3 in January of this year, and this business continued to deliver solid top line growth in the second quarter. Foreign exchange and average unit price significantly benefited the segment as well with 7% and 6% increases respectively. Growth in the second quarter was offset by a 2% decline in sales volume in the base business on a continued soft housing market in the UK, as Fred mentioned earlier. Europe delivered another good quarter for adjusted EBITDA expansion with a 51% increase over the second quarter of 2017, and adjusted EBITDA margin up 130 basis points to 13.5%. This was largely due to higher average unit price, which offset inflationary pressures and the inclusion of DW3, which is highly margin accretive to the UK business. On to slide 13, in the Architectural segment, net sales increased by 11% in the second quarter, primarily driven by acquisition growth of 12%, including both A&F Wood products which was acquired in the fourth quarter last year, and one month of results from the Graham & Maiman acquisition. The base business revenues were essentially flat year-over-year with average unit price growth of 9%, offset by volume declines of 10%. The result of steps we've taken to transform this business, including closure of the Algoma, Wisconsin plant in the second quarter of 2017, and shutting up some lower quality business, both products and customers. These actions were purposely designed to improve margins, but with the expectation that volumes could be affected for some period of time, as service levels were negatively impacted. This is indeed what played out, but we believe these actions have positioned this segment very positively for future growth. On the margin front, we continue to show great progress in the second quarter. Adjusted EBITDA was $12 million, up 60% from the same period of 2017, while adjusted EBITDA margin increased 450 basis points to 14.7%. As Fred noted earlier, this is double the adjusted EBITDA margin performance of this business in 2014, illustrating the potential for this business with continued emphasis on operational improvements in integration and a focused approach to improving average unit prices. Finally, before I hand it back to Fred, I'll close as usual with a recap of our current liquidity profile as shown on slide 14. Total available liquidity, including unrestricted cash and accounts receivable purchase agreement and our undrawn ABL facility, was $193 million or approximately 9% of our trailing 12 months net sales at July 1, 2018. At the end of the second quarter, total debt and net debt to trailing 12 months adjusted EBITDA were 2.3 times and 2.2 times, respectively. In the first six months of the year, the business delivered strong cash flow performance with cash flow from operations totaling $88 million, an increase of approximately $40 million as compared to the first six months of 2017, from improved profitability and working capital management. In the second quarter, we deployed approximately $39 million of cash to fund the acquisition of Graham & Maiman, the wood door division from ASSA ABLOY, and as mentioned earlier, we repurchased $16 million of our stock during the second quarter. Including repurchase activity, subsequent to the end of the second quarter, our year-to-date share repurchases have totaled $63 million. And with that, I'll turn the call back to Fred to summarize today's discussion.

[Frederick J. Lynch:]

Thank you, Russ, for that summary. So, to summarize our overall discussion, we're pleased with our performance in the second quarter, in which we delivered net sales growth of 9% and adjusted EBITDA growth of 15%. We're particularly pleased with our continued margin expansion, given the inflationary environment. Improvements in AUP across all three business segments has helped mitigate inflation, whereas our MVantage operating system is delivering real results to the bottom line. Cost controls and operational improvements across the organization, coupled with pricing, have allowed us to expand both gross margins and adjusted EBITDA margins. Further, we are consistently executing on our disciplined capital allocation strategy by continuing to invest internally to support further improvements in operational performance and productivity, pursue strategic M&A opportunities that we believe will add value to our business, and support our business strategies. And three, returning cash to shareholders by leveraging share repurchase programs to opportunistically acquire shares at prices that we believe offer good return. Given our performance through the first half of the year, we believe we are on track to achieve our 2018 outlook discussed in our fourth quarter and year-ending calls back in February. And with that, we'd like to turn the call to the operator to open up for questions.

[Operator:]

Thank you, Mr. Lynch. Our first question comes from the line of Mike Wood from Nomura Instinet. Please proceed with your question.

[Michael Wood:]

Hi. Good morning.

[Frederick J. Lynch:]

Good morning, Mike.

[Russell E. Tiejema:]

Good morning, Mike.

[Michael Wood:]

Good job with the gross margin improvement, despite the inflation headwinds. Can I confirm some of your opening comments seem to suggest that you offset price/cost headwinds with operational efficiencies? Is that true that you lagged inflation with price in the quarter? And are there any future price increases that have been announced? Or do you have visibility on when you can actually achieve that price/cost parity?

[Frederick J. Lynch:]

So, we did not say that we lagged on the price/cost piece. I think if you look at the slide on slide 10 that we showed, you'll see that that actually was positive. Productivity though was a nice benefit to us. And so, I think it was the combination of both that really drove it. Russ, I don't know if you want to add more color on that.

[Russell E. Tiejema:]

Yeah. Mike, I would just remind everyone that in November of last year, we implemented price increases. That was a little ahead of a more routine cadence of in the first quarter. And we envisioned that we would see some inflationary headwinds increasing as we got into 2018. So, we did our best to stay ahead of that. And to Fred's point, we've managed that price/cost relationship thus far pretty effectively, and we've tried to stay ahead of it. So, we really did see the benefit of both price increases really in effect through the first half as implemented in November of last year as well as this operational productivity. You also asked about additional price actions, whether or not we'd announced anything further. Recall on the Q1 earnings call in early May, we'd already confirmed that we were communicating to our customers some incremental price increases in the North American Residential that would go into effect in July.

[Michael Wood:]

Great. And that slide that you mentioned also includes mix there. And I know prior to last year where you had some execution problems, mix was a more front-and-center trend in the Masonite story. Curious, if you could just update us on where you are and how mix is trending, product introductions, product vitality, and how that's impacting your portfolio?

[Frederick J. Lynch:]

Yeah. Absolutely. So, I'd say that from a mix perspective, again, there's two components of mix. One is the mix that occurs within each of the businesses. So, we have product mix that we're driving through, as you mentioned, product vitality through the introduction of new products. The other component of mix I think which is important in this quarter to recognize is we did have that retail loss that occurred. And if you recall, retail products, our fully-hung, pre-hung products; oftentimes, we have products that are also pre-finished. So, as a result of that, since it's a different product than we sell in the wholesale channel, the entire retail channel has higher unit average pricing. So, when you have a relative increase in the wholesale channel, which we have very nice increases in the wholesale channel in the second quarter, and that's offset by a decrease in the retail channel, the net effect is it mutes what the overall average unit price should look like. I'm going to turn it up to Tony to talk a little bit about what's happening with new products, particularly in the Residential business, which is really one of the areas we're driving product vitality.

[James A. Hair:]

Yeah. I'd say, Mike, along those lines, we are – within the categories, as Fred described, we're very happy with the mix that we're achieving and the growth we're seeing in new products. We continue to drive that as a key initiative for us. And though we don't share our new product vitality, we are on target with our new product vitality metrics as we go through the course of 2018.

[Michael Wood:]

Thank you.

[Frederick J. Lynch:]

Thank you, Mike.

[Operator:]

Our next question comes from the line of Michael Rehaut from JPMorgan. Please proceed with your question.

[Michael Jason Rehaut:]

Hi. Thanks. Good morning, everyone.

[Frederick J. Lynch:]

Good morning.

[Russell E. Tiejema:]

Good morning.

[Michael Jason Rehaut:]

First, I wanted to talk about North America, and the volume puts and takes there. If you could remind us please when you'll be anniversaring the retail loss and how you think about your opportunity for volume growth going forward to back half of 2018 and into 2019?

[Frederick J. Lynch:]

So, this is the first quarter that was impacted by the retail loss last year. So, it'll take three more quarters for that to annualize, if that was you question. And then, with respect to – from an expected growth perspective, listen, we thought we grew very nicely in the wholesale channel, and that's more than in line with the market. So, we would anticipate that we'll continue to grow within – at the same rate as the market grows, if not better.

[Russell E. Tiejema:]

Yeah. And if I could just add to that also, if you take a look at the weighted average of all the end markets that we serve in North America, so remember, first of all, that new construction is less than half of our business in the North American Residential segment. The RRR Market is just over half. And 75% of our business there is in the U.S., the balance in Canada and Mexico. When we look at all of those different end markets, and we look at the weighted average growth that would be implied by housing starts, and what we estimate renovation growth to be, it suggests that the overall market probably grew in that 4% range roughly. So, if you look at the performance that we had particularly, as Fred mentioned, in the wholesale side of our business, where we were growing high-single digits, that gives us comfort that we're certainly staying with or even slightly ahead of the market.

[Michael Jason Rehaut:]

That's helpful, Russ. I appreciate it. I guess, secondly, when you talk about the lower – the negative mix impact from wholesale versus retail, I mean, a lot of businesses talk about a wholesale type of business or a direct-to-end user type of business as something which will typically have lower gross margins, but kind of offsetting that would be lower SG&A or overhead, and it kind of gets you to a similar type of operating margin. Curious why that isn't necessarily the case in this instance, and if there's any opportunities perhaps on the SG&A side or the overhead side to eventually bring those margins closer to retail.

[Frederick J. Lynch:]

First of all, Mike, we don't discuss margins between retail and wholesale. So, I'm not sure where that's coming from. But let me just be clear...

[Michael Jason Rehaut:]

Fred, I thought you said that the mix was down and that impacted margins because of greater wholesale.

[Frederick J. Lynch:]

No. Price, average unit price. Average unit price. So, let's just – just to help explain it again, in the wholesale market, we sell a door slab. In the retail market, we sell a door system. We sell different products to each of the different categories. When we sell a door system, which includes a pre-hung unit with frames, essentially hardware, finishing, by nature, it's going to be at a much higher average unit price. So, if you have a – if you're flat in one business and growing fast in the other business, your average unit price, which is a weighted average across your business is going to be lowered as a result of that.

[Michael Jason Rehaut:]

All right. No, I appreciate that. That was my fault. Sorry for the confusion.

[Frederick J. Lynch:]

No worries. I'm glad you asked that question. I want to make sure everyone has clarity on understanding that. So, it was important.

[Operator:]

Our next question comes from the line of Mike Eisen from RBC Capital Markets. Please proceed your question.

[Michael Eisen:]

Good morning. Thank you for taking the question. I just wanted to start off in the Architectural business. You guys talked about the rationalization you guys have done and the results are definitely showing in the margin profile. Given the fact that we're now a year into that process, should we start to see volumes coming through at a higher pace seeing some growth? And if that is the case, what are the type of incremental margins we should see from growth here now that you guys have taken a lot of these actions to fix the footprint?

[Frederick J. Lynch:]

Yes. So, I think this is an important quarter for us, as we move from a one year lapse, an anniversary of the shutdown of the plant that we had last year. We – if you think about the Architectural transformation, it really went through most of the summer last year as we reduced the number of product offerings, then we consolidated the portfolio and went to single branding, et cetera. That did impact our customers during that time. And so, given the lag time in that market of 6 to 12 months from the time of order to the time of actually ultimate delivery, our anticipation is we're going to start to see that growth in the second half of the year. Again, from an incremental margin basis, we look at that business as the same as we look at the rest of our business at this point in time on an incremental basis. Graham, I don't see anything else. You want to add to that?

[Andrew G Thayer:]

No. I think we're just seeing the carryover from all the changes we did last year which, as you've seen, has a great improvement on the bottom line, but it's taking a while for the orders to flow through, given the lag time. So we are seeing an improving trend, and we expect things to continue on that trend.

[Frederick J. Lynch:]

Did that answer your question?

[Michael Eisen:]

Got it. It's really helpful.

[Frederick J. Lynch:]

Okay.

[Michael Eisen:]

Very much so. And then, just switching over to the European business. Russ, I believe you mentioned that DW3 has some solid growth in the quarter. Can you help us understand the different channels you guys are in and what you're seeing in growth rates to really dissect what's going on in the volume side?

[Russell E. Tiejema:]

Sure. When you step back and you look at the Europe segment, which is principally our business in the UK, we effectively have a portfolio across all product categories and we really can sell through multiple routes to markets. So, we serve the merchant channel, the contractor channel on the renovation side via both DW3 and our Door-Stop business which we own since early 2014, as well as the builder and distribution channel via our National Hickman business. We've seen lumpy growth, I would say, overall in the UK, just given the tepid environment in both the economy and in the housing market there. But I will say on the DW3 side, more specifically to your point, we've been really pleased with how that business has continued to perform. If you recall when we announced at the Q4 earnings call about acquisition, we highlighted that that business had trailing 12 months net sales in the range of about $60 million and EBITDA in the range of about $11 million. So, that would imply high-teens, 18-plus-percent EBITDA margin. And we've seen that business continue to grow net sales, and continue to drive even higher on the margin side. So, it's been a great acquisition for us and accretive to the overall UK business.

[James A. Hair:]

The only color – this is Tony, Mike. The only color I'd add is, still a large exposure to the builder side in the UK business and we have seen that slow down. You've seen it in the start and completions numbers. We're confident it's going to get back on track, but we have seen that impact both first and second quarter in terms of overall volume. And to Russ' point, very excited about what we're doing in the contractor channel and the remodel channel both through DW3 and through our DSI business.

[Michael Eisen:]

Got it. Thank you, guys, so much.

[Frederick J. Lynch:]

Thank you.

[Operator:]

Our next question comes from the line of Kathryn Thompson from Thompson Research. Please proceed with your question.

[Steven Ramsey:]

Good morning. This is Steven on for Kathryn. On Architectural M&A with Graham & Maiman, I would be interested to hear a couple of things just more specifically how that improves your geographic and product coverage, and then the margin profile of that business. And do you have to do a lot of work to take that up to where you already are in that business?

[Andrew G Thayer:]

Yeah. Steven, it's Graham. The geographical improvement we get with both plants is that we're able – both in Iowa and in Missouri, we're able to service Texas a lot better and also in the West. If you look at our network that we have right now, we're very well covered in the East. We have a very comprehensive network of door plants in our quick ship business. So, clearly, we have opportunity to move westward with that business, and we saw that as the main opportunity in the acquisition. As far as margins, it's consistent with the rest of our business, so yeah, we expect that to carry on.

[Russell E. Tiejema:]

Yeah. The only thing that I might add there on the acquisition side, specific to Graham & Maiman is obviously, as we've carved assets out and integrated them into the business, there are some integration costs that we're going to be incurring as we go through the balance of 2018. We said that by the time we hit the second year of ownership in this business, we would be on track for double-digit EBITDA margins more comparable to the rest of the business. But there is some integration time and cost required the balance this year. So, this would not be margin accretive. It would be slightly margin dilutive to the business balance of the year.

[Frederick J. Lynch:]

Again, long term, what we really like about the business is we are backward integrated as opposed to other folks in this space. And so, the opportunity to feed those new plants with components from our existing plants is a real positive.

[Steven Ramsey:]

Great. And then kind of stepping back, even maybe thinking more philosophically about pricing strategy, how you guys moved ahead of the inflationary pressures with your price increases in November of last year? Maybe just looking back, do you feel good that you moved ahead of that inflationary pressures and with being in such a dynamic environment of inflation and tariffs, is it something where you try to continue to move ahead? Or do you step back a little bit, hold off, and see what happens and then postpone raising prices? Just trying to get a grasp of how this environment affects your outlook on pricing.

[Frederick J. Lynch:]

So, I would say that one of the things I take great pride in is that our teams both on the purchasing side of the equation, and the teams leading the businesses work very well together and take a lot of time to really understand the nuances in a very credibly dynamic and difficult timeframe to understand where raw material cost is going to go, given the trade situation that we have. But our teams are all over that on a day-to-day basis. As you've seen, we've been much more aggressive and – or much more frequent in our pricing actions over the last nine-month period. So, that's part of the part of the reason that I think we've been successful at keeping this price/cost relationship in check. Russ, maybe you want to talk a little bit about the future look of the dynamics.

[Russell E. Tiejema:]

Yeah. What I might just offer a little bit of color on since you specifically noted tariffs, and as Fred mentioned, it's a pretty dynamic environment right now relative to trade policy, and where this ultimately lands for us is pretty unclear. But I guess I would like to put a few things into context for folks. If you take a look at the most recent conversations around potential incremental tariffs on Chinese sourced material, just to put in context for the Masonite business, approximately 10% of our total material cost is associated with China sourced content. So if you look at inclusive of the acquisitions that we have made, you've got a material cost footprint that's going to be in excess of $900 million this year, and about 10% of that is going to be China sourced product. Now, we're the importer of record for about half of that China sourced content. So that's where the tariffs would most directly impact us immediately, if they were to go in place. It's entirely possible though that tariffs would create some inflationary pressure on the Chinese material that we source via other importers. But frankly, it's a little difficult to predict at this time just how much net impact we might face from that, considering offsetting factors such as the weaker Chinese RMB versus U.S. dollar. And we do all of our purchases in U.S. dollar presently. So, the bottom line of all that is our sourcing team is working very aggressively to understand what the impacts are and where, if necessary, we could move our supply chain, if tariffs do materialize. We manage a global supply base. We've evaluated carefully the materials that do come out of China. We estimate that we could probably move up to 40% of that buy on a very near-term basis. And we've got alternate sources of supply of over half of the material that comes out of China. So, bottom line is, we'll continue to monitor the situation. It is dynamic, but we feel like we've got a good handle on the actions that we'll need to take to achieve lowest landed cost, and hopefully manage – continue to manage these price cost dynamics, wherever possible.

[Steven Ramsey:]

Great. Thank you.

[Frederick J. Lynch:]

Thank you.

[Operator:]

Our next question comes from the line of Josh Chan from Baird. Please proceed with your question.

[Josh K. Chan:]

Hi. Good morning, everyone.

[Frederick J. Lynch:]

Good morning.

[Josh K. Chan:]

Thanks for taking my questions. So, on the wholesale business, you definitely saw very strong growth there. Do you think you're gaining share? And if so, kind of what are some of the drivers behind it? And then also is there any dynamics to think about with respect to either channel inventory or pre-buy ahead of price increases, anything like that?

[Frederick J. Lynch:]

Yeah. I think on the question of share, I don't think there's a good independent metric on that. We're satisfied with the growth. As Russ mentioned, we believe when we consolidate across new build and remodel, we were at least at market level for our growth in Q2 in wholesale. And our drivers continue to be service to the customers, and then driving new products. As we talked about mix earlier, moving into higher value products for both us and our customers is really important, and we've seen success in that through the quarter.

[Russell E. Tiejema:]

Just as an example, the new Heritage product that we brought to market just a couple of years ago on the interior side is now exceeding 10% of our sales in the wholesale channel, so it gives you an example of what the impact of new products can do.

[Josh K. Chan:]

All right. And then – so just to follow up on that, do the wholesalers typically pre-buy ahead of increases or is that not really a meaningful dynamic, pricing (42

[Frederick J. Lynch:]

Yeah. We've talked about this before in the past though. We don't see – unlike some products that are more compact and higher value for the volume that they take up, doors are rather large and bulky items. So, as a result of that, we don't have the same impact that you might see, for instance, in a roofing shingles business, where there can be a lot of pre-buy for months of supply. We typically believe that the pre-buys are going to be, at the most, a week or two weeks, something like that.

[Josh K. Chan:]

Okay. Yeah. Thanks for the color on that. And then my second question is, Fred, you mentioned a slight reduction in the number of doors in single-family homes. Just wondering from a magnitude perspective, how significant is this effect and is there anything that you guys are doing to sort of offset that either via mix or new products or anything like that.

[Frederick J. Lynch:]

Yeah. I'd say that the work we've done thus far in looking at floor plans of new builds that go into the market that, in some of the new build models, you can see a reduction in number of doors between 10% and 20% – up to 20%, probably closer to that lower end. So, I think what's the focus though is that we – and we continue to push that is the value of a solid core door or a new design like the Heritage Series, or even in the case where we're seeing remodeling where people are changing out their doors and putting barn doors in, for instance, which is going to be a much higher value interior product for us. So, our marketing teams, I think, are really focusing on looking at trends and making that door category much more relevant. As the number of doors decrease, we want to make sure that the value per opening, we're maximizing that with the highest value product that meets what the customer is looking for. And for us, that's about communicating to the customer and empowering them to understand how we can change the look of their home through door design. And I think our team is doing a great job from a marketing perspective, making that happen and you see that in the increase in the number of new products and the vitality index. That's not just the product, but it's the marketing that goes along with it.

[Josh K. Chan:]

All right. Great. Thanks for your time and good quarter.

[Russell E. Tiejema:]

Thank you.

[Frederick J. Lynch:]

Thank you.

[Operator:]

Our next question comes from the line of John Baugh from Stifel. Please proceed with your question.

[John Allen Baugh:]

Thank you, and good morning, and congrats as well. I wanted to touch on, I guess, transportation costs. And I'm looking at page 10, where you highlight distribution or the little green box of $1 million. I guess a couple of questions is, where is freight and the fuel and all these related factors in your P&L and specifically in this adjusted EBITDA bridge? And could you maybe give us the pluses and minuses that are going on as it relates to distribution and freight and fuel and sort of what the outlook is prospectively in terms of being able to stay in front of that? Thank you.

[Russell E. Tiejema:]

Sure. Good morning, John. It's Russ. So first of all, just for clarity on how we present distribution in our P&L, it is considered part of our cost of goods sold. And that would include several elements. It would include any distribution labor that we have within our manufacturing plants that are responsible for the actual packaging and loading of product per shipment. It would include the carrier rates that we pay to our carriers for actually shipping that as well as any supplemental of fuel cost over and above that rate. If you take a look at our distribution cost as a percentage of sales in the quarter, we saw a pretty significant improvement, over 70 basis points as a percentage of sales year-on-year. And we've been able to attack that on multiple fronts. We've gotten more efficient at how we deploy our distribution labor in the plants, and how they're actually packaging the products, so that we can more fully cube or weight out trailers, that's improving our actual payload efficiency with the shipping that we're doing. And we've also done a good job of maximizing our freight line effectiveness through the load and route planning. And then, frankly, because we've improved operationally in the plants as well, our service levels improved, on-time delivery has improved, and that's helped us reduce less than truckload shipping, which obviously has a lot higher rate with it. So, we're reducing our reliance wherever possible on spot rates, and we very carefully manage contracts with our strategic carrier partners and that's allowed us to reduce costs in some of our dedicated fleets, and really be more optimal about our freight line planning. So, I would say it's a combination of all of those factors. Now, this is going to continue to be a focus area for us because as we look ahead, despite all of those things that we're doing to carefully manage the contracts with our carriers that service us and to avoid the spot market. We would still expect that we could see a mid-single digit inflationary rate in distribution-related costs. So, it's an area we're going to have to continue focusing on the balance of the year.

[John Allen Baugh:]

And, Russ, thanks for all the details. So, the expectation, has it been mid-single digit sort of the past six months here? And you've been able to offset that with all that and that's the expectation going forward, and then I guess you get some pricing in July as well. So, I guess, a short question we're still looking at a green or kind of breakeven on that prospectively?

[Frederick J. Lynch:]

Yes. I think one thing is important to describe. It's Fred again. If you recall, when we – in last year, 2017, that bar was over $20 million negative for us. So, we had a very difficult distribution challenge as we went through last year, and it's a large part of some of the operational headwinds that we ran into. I think the good point here is, we have gotten that behind us, but we want to recognize that we're working off a base of a negative number in 2017, that we've been able to correct. I think what Russ is saying, from a market perspective, we – right now, freight and logistics continue to be a challenge across all industries. And so, we feel that our teams have to continue just like we did with the raw material piece and, now, the level of data and focus that our logistics team is putting in place to make sure that we mitigate the impacts of those inflation is critical. And that it is a large part of our cost structure and, therefore, it gets and deserves a lot of attention by our team to make sure we're driving that in the right direction.

[John Allen Baugh:]

That's helpful. Thanks. Good luck.

[Frederick J. Lynch:]

Thank you.

[Operator:]

Our next question is a follow-up question from Michael Rehaut from JPMorgan. Please proceed with your question.

[Michael Jason Rehaut:]

Hi. Thanks for taking my follow-up. You've mentioned earlier in the call that you kind of initially budgeted 3% to 3.5% cost inflation for 2018 entering the year and that first quarter 2.5%, second quarter approaching 3%, and in the back half likely to hit the higher end of the range. Just wanted to get a sense, I mean obviously you talked about the price increase in July going through as an incremental action, but that essentially, you're on track, it sounds like you are, but just kind of curious on your thoughts. And in terms of offsetting that or maintaining the full offset, in other words, maintaining the positive price cost dynamic that you've already been able to achieve in the second quarter, that despite the creep up in cost of inflation that via either through the July price increase or other productivity actions that we should still kind of anticipate a positive price cost differential?

[Russell E. Tiejema:]

I think just to be clear – this is Russ. The outlook that we have got out there for inflation, to your point, 3% to 3.5% at the beginning of the year, we now think we'll be at the upper end of that. That's excluding any incremental tariff impacts. And at this point, that's difficult to predict. But bottom line is, we feel good about our ability to continue to focus on average unit price improvements and bring additional pricing to market to help us cover those costs. I think to some degree in the second half, it's a degree of magnitude. And what happens with the tariffs, how quickly will they come into place, how quickly can our sourcing team respond to move some of the supply lines for that, and then obviously we'll take into account pricing where necessary to do our best to manage that price/cost relationship. But it's a pretty fluid and dynamic environment at this point in time.

[Michael Jason Rehaut:]

Just to be clear, when you're talking about heading to the high end of that range, tariffs aside, are we still talking about maintaining the positive price costs given some of your actions, and that's part one? And then two, as perhaps the tariffs kind of fold into the business in the third and fourth quarter, is that going to be something that would be able to be dealt with in real time or something that there would be some type of lag?

[Russell E. Tiejema:]

The answer to your first question is yes, it would be our expectation that we would be able to manage that price/cost relationship effectively. And to part two, with respect to tariffs, it would also be our intent to address that to the greatest degree possible via pricing.

[Michael Jason Rehaut:]

Thank you.

[Frederick J. Lynch:]

Thank you.

[Operator:]

At this time, we have no more questions. And I would like to turn the call back to Fred Lynch for closing remarks.

[Frederick J. Lynch:]

Thank you, and thanks, everyone, for joining us today. Again, we believe that we are positioned well for future success of our business segments and that there are still significant opportunities to improve the performance of our business. And we remain committed to being the best provider of building products in the eyes of our customers, our employees, our shareholders, our suppliers, and our communities. And I do want to take the time to thank the Masonite team of 10,000 employees that work tirelessly to deliver on our 2018 targets as we continue to help people walk through walls. Thank you, each and every one of you. Look forward to updating you on our next quarterly earnings call. We appreciate your interest and continued support, and this concludes our call. Operator, will you please provide the replay instructions?

[Operator:]

Thank you for joining the Masonite International second quarter earnings call. This conference call has been recorded. The replay may be accessed until August 23. To access the replay, please dial 877-660-6853 in the U.S. or 201-612-7415 outside the U.S., enter conference ID #13681278.